Study asserts link between control weaknesses, fraud

Authors of a new academic study say they have identified a link between material weaknesses in internal control over financial reporting and later revelations of fraud, lending fresh support to key provisions of the Sarbanes-Oxley Act.

The study out of the University of Texas and Texas A&M finds the issuance by an auditor of an adverse opinion on internal control is a red flag for fraud. The authors say the study finds “a statistically and economically significant association” between material weaknesses in controls and subsequent fraud discoveries. The association is driven by instances where problems with internal control reflect “a general opportunity to commit fraud,” rather than account-specific or process-specific control deficiencies.

Where companies have been found to have material weaknesses in internal control, the research says the incidence of subsequent discovery of fraud is approximately 80 percent to 90 percent greater than across firms generally. In the study sample, almost 30 percent of the 127 fraud cases examined were preceded by auditor reports of material weakness in internal controls.

Questions persist on whether the costs and struggles associated with internal control reporting and auditing under Sarbanes-Oxley are justified by the benefits. A House of Representatives subcommittee is looking into why the number of public companies has fallen by roughly half over the past two decades, including whether internal control reporting and auditing under SOX has been a factor.

Published in a recent academic journal of the American Accounting Association, the study lends support to those requirements established under Sarbanes-Oxley in 2002. The authors says the longstanding debate over whether the strength of internal control affects the risk of fraud has been informed by little direct evidence, until now. They believe the study supports the notion that weaknesses in entity-wide controls rather than process-level controls are associated with a higher risk of reporting fraud.

Investors, regulators, and legislators should take an interest in the fact that material weakness reports precede fraud discoveries in nearly 30 percent of cases studied, the authors say. It suggests that the Section 404(b) provisions of Sarbanes-Oxley, which require auditors to issue an opinion on internal controls, provides a potential benefit as an early warning system for fraud, they say.

“Given the criticism of SOX and discussion in favor of its repeal or curtailment, this benefit is an important consideration alongside the costs of internal control reporting,” the study says.